Bitcoins, and the universe of cryptocurrencies

A quick introduction to the universe spawned by the creation of bitcoin.

[Disclaimer (13/08/2014): This article is old. If you are looking for an up-to-date perspective, you will probably find a better one elsewhere as a number of exciting developments took place over the course of the last year — not only in terms of venture capital backed companies, but also in terms of technology. I will write an updated article as a find time.]

With the recent price increase and public attention, Bitcoin makes it into the news quite frequently. Are you aware of the whole cosmos of digital currencies created by bitcoins? Bitcoin is just a platform prototype for electronic money, not a finished and fully furnished end user friendly product.

Between specialized hardware for mining bitcoins, (stock) exchanges trading companies valued in, and operating with bitcoins and maybe more notable, a plenitude of currencies, called alternative coins, altcoins in short, constructed from the blueprint created by bitcoins, there is a lot more to come.

Read about mining coins, alternative cryptocurrencies and bitcoin stock exchanges — paragraphs should be self-contained, skip as you want.

Bitcoin as a Protocol

The core idea and contribution of bitcoin is a peer-to-peer distributed, public ledger of all Bitcoin transactions. There are a number of proposals the use Bitcoins as a vehicle to implement Bitcoins with identity, especially colored bitcoins. A more recently implemented instance of a proposal is Mastercoin. There is an awesome article on Mastercoin. These “second generation” protocols/cryptocoins can be used to implement tracking of share ownership, peer to peer markets or contract-for-difference style betting directly in the blockchain: Instead of just holding a certain amount of coins, it tracks specific instances of coins, just like tracking a real penny.

There is a number of distinct advantages to using Bitcoin instead of an independent cryptocoin network for extensions like Mastercoin and colored coins: the stability and robustness of the huge computing power backing up the Bitcoin network makes it very hard to attack these protocol extensions, and since they are invisible to normal Bitcoin miners, there is a lot of computing power waiting to process their transactions, too.

Mining Coins and Hardware

Originally, mining bitcoins was done with the processor of your computer, the CPU, own your own (called solo-mining). The computer calculates hash values, using an algorithm called SHA256. Simplifying the process of creating bitcoins, your computer calculates hash values for a certain set of inputs for a while, until certain criteria are met. This hash value together with the input constitute a proof of work (in short POW). With a considerable increase in bitcoin miners, solo-mining became less attractive — it is more or less random whether you find bitcoins. Mining pools share the workload and you are less likely to waste a lot of time without finding anything.

While the algorithm requires a lot of number crunching, today’s processors are not the fastest doing this and the mining software was quickly extended to use graphic cards, calledGPU miners. These are a lot better doing arithmetic. But even these quickly became outdated despite a speed increase by the factor of 10 and more by FPGAs, a form of customizable hardware. Once programmed, they only solve one task, being highly specialized. They are only outpaced by ASICs, specialized hardware. In contrast to FPGAs, which are re-configurable multi-purpose CPUs, an ASIC is out-of-factory specialized on solving one task — mining bitcoins.

Summary

Summing up, the transition went from solo-mining on a CPU to mining together in pools, over to using GPUs of graphics cards to using adoptable hardware, FPGAs over to specialized hardware usable just for mining bitcoin, called ASICs.

Alternative Cryptocurrencies

Bitcoin is publish as open source software. You can see and modifiy the code, basically creating your own copy of the bitcoin network. The interesting part is that bitcoin has a few parameters that can be changed: the total number of coins and the speed of distribution are the most visible ones. There will never be more than 21 million bitcoins by construction, reached in year 2140 . Other parameters influence the speed of transation and the number of confirmations required for a transaction to go through.

More interesting parameters are the hashing algorithm used. There is a wide range of alternative to bitcoins SHA256, and the most notable one in terms of cryptocoins is scrypt used by Litecoin and others. Advantages of these algorithms are e.g. higher use of memory, making it harder to mine them with ASICs. In terms of resistance against specialized hardware, Yacoin might be particularly interesting: its scrypt algorithm is equipped with a parameter that regularly gets updated and leads to increased memory consumption while mining.

A really interesting alternative is given by Primecoin which contributes to scientific research by replacing the “stupid” hashing algorithms with the calculation of specific sequences of prime numbers.

Another feature to change is given by the security proofs. Bitcoins provide security by requiring proof-of-work. There is an alternative scheme, called proof-of-stake (in simpler terms). Proof of stake schemes can limit the mining power to the relative ownership of all coins, and are often used together with proof-of-work to enable interest generation. PPCoin is an example of such a coin. Speaking of interest, another interesting coin is Freicoin. Its network enforces a demurrage fee, creating a high speed of cash flow. It is important to note that a proof-of-stake scheme will make a network more secure against a 51% attack.

A more democratic approach to regulate the parameters of the currency is given by netcoin, the allows its users in regular intervals to vote on the interest rate.

Dangers of Altcoins

Altcoins come with their own problems: since transactions are verified by a consensus in the coin’s network, if someone manages to get more than 50% of the networks power, he can force a wrong consensus on themselves spending their coins multiple times. This is known as the51% attack. Since new altcoins have their own network, they tend to be small and it is rather easy to rent some virtual servers (e.g. from Amazons AWS services) to start a 51% attack. That actually happened to the powercoin (PWC), and it is quite easy. You will find instructions to run Amazon Mining instances everywhere, and it is not difficult at all.

Someone has to start a new coin. If they start to mine before giving the mining software to the public, they can create a lot of coins for their own before anyone else. This is known as pre-mine,and of course is considered bad because it skews supply vs. demand.

Summary

There are lots of cryptocurrencies, for a number of reasons: being late to the bitcoin party, adding new and interesting features to make cryptocoins more secure against (a) attacks on the network itself,e.g. adding proof-of-stake schemes(b) mining with specialized hardware, e.g. using memory intensive or self-adopting hashing schemes. Before investing in them, make sure there is no pre-mine and that the network is stable enough.

Bitcoin Stock Exchanges

Instead of just buying bitcoins by exchanging fiat currency into bitcoins, you might consider buying options or futures on the price of bitcoin. At mpex you can find regularly settled and traded contracts.There are also crowdfunding sites as well as virtual stock exchanges like bitfunder and others, allowing to invest and trade shares of companies valued in bitcoin. Examples are giving by s-dice, a bitcoin gambling site and ASICMINER, a hardware/mining company. Some of these companies have a market cap of several million dollars. Some places also offer bonds with fixed interest or shared mining profit. There is bitcointalk subforum on securities.

Personal Thoughts

While it seems clear that bitcoins are the clear winner in terms of volatility/stability, network safety and also liquidity, I think it is still a prototype in the wild. None of the alternative currencies has a clear and big enough advantage to replace bitcoins, but they already address issues that will come up with bitcoins: e.g. a much higher network volume or the computation power needed to maintain the network, especially once all coins are mined and given out. Bitcoin payments are not completely private and anonymous.

An interesting way out of the tractability of bitcoin payments (everyone can read the public ledger, though it only shows IP addresses and Bitcoin addresses, that might be harder to connect to real identities) is given by Zerocoin. It extends the existing protocol of Bitcoin and therefore is harder to attack than a new altcoin currency with its own (slower than Bitcoin’s) network.

Disclaimer

This article contains quite a number of simplifications. It does not replace your own research, nor does it constitute any form of investment advice. I also point out that I do own some bitcoins, litecoins, yacoins and primecoins.

You can reach out to me on twitter at @chrshammmr and test your bitcoin sending skills with the address 1JA4haou9Z4KT33ZucncT1CsEJdkZf3UAo